A Static Analysis of The Customs Union Issue
customs union which diverts trade away from C, the customs union will be beneficial to A if the new indifference curve is higher than I3, If it is lower than I3 then country is better off imposing the non discriminatory tariff. If however the indifference curve is higher than I3, then A’s welfare would be increased implying that trade diversion is not always bad.
Theoretically Lipsey’s argument is sound but we cannot really make conclusions on counting optimal conditions but further analysis by him in “A Theory of Customs Union: A General Survey” , suggests that the more trade that takes place between the union members in comparison to trade with countries not in the union then the more likely it is that the consumption effects will be positive and the lower the pre union trade by the member countries will lower the possibility of negative consumption effects. But this must depend on the original tariffs between the union countries, if the initial tariff was high then the consumption pattern will be severely distorted, but eventually as more new trade is created the consumer satisfaction per unit of trade will increase. If high tariffs are kept in place against country C then there will be a loss in welfare that results from the reduced imports.
Although Lipsey’s theory shows that trade diversion can be good for welfare in certain circumstances it does not move away from the fact that trade creation is the more favourable option. A customs union is in itself economically a second best option , but it is important for trade creation and in turn welfare to predominate. A low demand for C’s products and a high demand for those produced in the customs union will cause trade creation. The greater the common external tariff, the more trade is created, the flatter the supply and demand curves, the greater the trade creation areas, the more countries that participate in a customs union lessens the chance of trade diversion, this means that the probability of trade diversion will decrease as more countries are added as there are only a finite number of countries in the world. It is advisable that integration occurs between neighbouring countries as they will see the real impact of integration by reduced transport costs. If the countries that form a union have a competitive production structure then there must be better substitute goods so there will be an increase in trade and positive consumption effects. If however there is complementarity between the goods of the countries, then there will be little reduction in imports anyway and the countries within the union will not see as much gain. The more small firms that exist within an industry, the smaller the potential for resistance and the greater the competition within an integrated market.
In this analysis, I have only looked at the static economy, of course in reality it is very different, all of these theories discussed only really hold true due to their assumptions, studies into the [next page]